ERE10: Instruments of Environmental Policy Criteria, incl. cost-effectiveness Instruments –Institutional –Command and control –Market based A comparison

Last week Optimal targets –Flow pollution –Stock pollution When location matters Steady state –Stock-flow pollutant Steady state Dynamics Alternative targets

Criteria Cost-effectiveness Dependability, environmental effectiveness Information requirements Enforceability Long-run effects Dynamic efficiency Flexibility Equity Uncertainty

Cost-effectiveness The firm‘s abatement cost The least cost formulation The Lagrangian The necessary condition Marginal costs are equal for all producers

CiCi ii The firm’s abatement cost function Emissions

   5   Pollution abatement Z MC A = 3Z A MC MC B = 5Z B   Marginal abatement cost functions for two firms C A = Z 2 A C B = Z 2 B Pollution abatement:Current emissions:Abatement target:

Cost-effectiveness (2) Least-cost implies that the marginal cost of abatement is equalised over all polluters This will in general not involve equal abatement effort by all polluters Where abatement costs differ, relatively low-cost abaters will undertake most of the total abatement effort

Instruments: Overview Institutional –Bargaining –Legal redress –Information, awareness, responsibility –Property rights –Voluntary agreements Command and control –Inputs, technology –Output (product, pollutant) –Location (source, individual) –Timing –Prohibition Market-based –Taxes (inputs, outputs) –Subsidies –Tradeable permits

Institutional Instruments Coase (1960) Theorem: The social optimum can be established through bargaining between polluter and victim Alternatively, the court may step in Or, the government may appeal to the polluter‘s conscience Or, the government may establish property rights

Command and Control Command and control = direct regulation It is the most common form of environmental regulation, reflecting a natural science frame of mind, and highly successful in past management of point sources of toxics Essentially, command and control prescribes aspects of the production process, be it inputs, production or outputs Requires substantial knowledge on the part of the regulator (e.g. abatement cost function of each firm) Requires homogenous producers

Types of Direct Regulation Inputs, e.g., fuel efficiency Technology, e.g., catalytic converters –Best practicable means –Best available technology (not exceeding excessive costs) Outputs –Products, e.g., carcinogenic toys –Waste, e.g., sulphur emissions Timing, e.g., air traffic Location, e.g., nature reserves Prohibition, e.g., CFCs

Taxes and Subsidies Taxes: Pay a charge or levy or penalty for every unit consumed, produced or emitted –It is levied on emissions, not output –Encourages substitution effects Subsidies: Receive a premium for every unit not consumed, produced or emitted Uniform taxes and subsidies have a uniform effect on marginal production costs, thus ensuring efficiency Taxes and subsidies have an equivalent effect on emissions in the short run, but have different budgetary distributional, and long-term effects

An economically efficient emissions tax 0 Z * =Z ** Marginal benefit (before tax) 0 ** Marginal benefit (after tax) M*M* M Marginal damage Marginal cost of abatement Marginal benefit of abatement The economically efficient level of emissions abatement

Tradeable Permits The government sets an overall target on consumption, production or, most common, emission Each producer obtains a certain amount of emission permits, can sell these, or buy more at the market place Creates property rights If the permit market is perfect, all producers pay the same price, and marginal costs of production increase uniformly Taxes and tradeable permits are equivalent provided that the regulator knows the marginal abatement costs

Permits: Initial Allocation Auctioning –Sell permits to highest bidder –Generates revenue, perhaps a lot Grandfathering –Give permits to current polluters –Politically easy, as confirms status quo To victim –Perhaps fair, definitely complicated –May generate large transfers Per capita –Perhaps fair, relatively easy –May generate large transfers

   5   Pollution abatement Z MC A MC MC B Marketable permits and efficient abatement 

Voluntary Agreements Environmental regulation requires a lot of knowledge, perhaps more so than at the disposal of the regulator Increasingly, governments and industry negotiate over emission targets, the results of which are laid down in a voluntary agreement This is a euphemism, as the government typically threatens to intervene if no voluntary agreement is used Voluntary agreements make optimal use of the information within industry but have a problem with public acceptability

Cost-Effectiveness Market-based instruments are cost- effective Command and control is unlike to be cost- effective, unless the regulator knows a lot and the industry is homogenous Institutional instruments may be cost- effective (voluntary agreements), and even efficient (bargaining, property rights) Tradeable permits may also be efficient, if people buy (hold) but not use (sell) permits

Cost-effectiveness (2) Cost function: Least cost formulation: Necessary condition: Taxes, subsidies and permits:

Environmental Effectiveness The environmental effect of taxes and subsidies is uncertain (but its marginal costs are certain) The environmental effect of tradeable permits is certain (but its costs are uncertain) The environmental effects of emission standards are certain (bar illegal dumping), of input and production standards less certain The environmental effects of institutional instruments are uncertain, and unpredictable as enforcement is not in the hands of the government

Environmental Effectiveness (2) taxespermits *=(t*)  *=)t* t* 1 2 M* M1M1 M2M2 * L*(=M*) L*=(M*) A* A1A1 A1A1 A2A2 A2A2

Dynamic Effects Taxes and tradeable permits provide a continuous incentive to emit less Subsidies have the same effect, but may attract new entrants Direct regulation is static; once the standard is met, there is no need to further reduce emissions Unless, standards get stricter over time Institutional instruments are mixed

Flexibility Flexibility is important, as new information may arise It is easy to lower taxes, make standards less strict; it is hard to do the opposite The exception is tradeable permits, where the government can release new permits but also buy existing ones

Equity Different instruments have different distributional consequences In general, environmental policy makes things more expensive; with cost-effective instruments, this effect and hence the distributional effects are less pronounced If necessary (luxury) goods are regulated, the environmental policy is regressive (progressive) Tradeable permits have as advantage that cost-effectiveness is secured by the market, and equity perhaps by the initial allocation

Uncertainty Welfare losses can occur as a result of the (unknowingly) selection of incorrect targets Overregulation is more (less) costly with taxes than with standards if the marginal damage cost curve is steeper (flatter) than the marginal abatement cost curve

t*t* M*M* Emissions, M MD MC (true) MC (assumed) tHtH LHLH MtMt Loss when licenses used Loss when taxes used Uncertainty about abatement cost – cost overestimated

t*t* M*M* Emissions, M MC (true) MC (assumed) tHtH LHLH MtMt MD Uncertainty about abatement cost – cost overestimated (2)

t*t* M*M* Emissions, M MD MC (true) MC (assumed) tLtL L MtMt Uncertainty about abatement cost – cost underestimated

t*t* M*M* Emissions, M MC (true) MC (assumed) tLtL L MtMt MD Uncertainty about abatement cost – cost underestimated (2)